Early Withdrawal

Archive for October, 2009

Question: Ways to reduce income tax when you began making IRA withdrawals?

Any ideas to save on income tax before one has to start making withdrawals from IRA?
I thought one way would be if you’re 67 years old and you know you will have major medical expenses in these next 2 years, should you withdraw some out of your IRA since you will be able to deduct the medical expenses from your taxes? Otherwise, if you wait till 70 1/2, then you will not have the deduction benefit.
Any other ways to save income tax when you start making IRA withdrawals?
great answers so far.
The medical expenses are for procedures to be done this year and the next year, afterwards the amount spent on medical expenses will be less than the 7.5% of income required (no more procedures needed- otherwise healthy person).

Answer: You have substantial assets inside a tax-deferred traditional IRA and now you are facing a big tax bill when you take those required minimum distributions.

It is smart to see that those RMDs are going to bump you into a higher tax bracket and to plan ahead. You can start to draw the money out of your IRA as soon as you are 59.5. One strategy is to figure how much you can take out each year and not go into the next higher bracket, and take that out before age 70.5. You will not be paying higher tax on it, and it will reduce the balance in your account, and thus reduce your RMD.

If you do not need or want to move the money into an after-tax account or spend it now, you could figure the amount of withdrawal that doesn’t bump you into another tax bracket, and move that amount into a Roth IRA each year. You will pay regular income tax on the rollover, but the amount rolled over plus earnings is tax-free when you take a distribution, and is not subject to RMD. You can do this as long as your AGI (before the IRA rollover) is under $100K. This restriction disappears in 2010.

A taxpayer with this problem should consider switching current contributions to a Roth rather than a traditional IRA, since the current deduction may not be much benefit, and you want to reduce the RMD in a few years.

Once you reach age 70.5 and are subject to RMD, if you make charitable contributions, do them as charitable rollovers from your traditional IRA. These charitable rollovers can be used for RMD and are tax-free.

If you plan on doing Roth rollovers, get them done before you start your Social Security benefits. Roth distributions do not increase tax on SS benefits. This is another reason to move as much as you can from your traditional IRA to your Roth IRA before the RMD and SS benefits begin.

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Question: Roth IRA? I had to make an Early Withdrawal?

I have recently lost my job and unemployment is not covering all the bills! I have had to take some money from my IRA and I am wondering about the penalty and amount I am going to have to pay when I file my taxes.

Answer: I assume this Roth IRA was not converted from another retirement investment.

Your original contribution can be taken out tax-free. If you are under age 59.5, your earnings are going to be taxed and there will be a 10% penalty added as well. Use Form 8606 with your tax return to figure the tax and penalty.

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Question: I want to make an Early Withdrawal from my SEP-IRA. What can I expect in penalties & taxes?

I spoke to my financial advisor about withdrawing money early from my SEP, but I’m confused. I assumed that if I wanted to withdraw $12,000-$13,000, then I would get that amount “cash-in-hand”. I would then have to pay the 10% withdrawal penalty and income tax (I’d get Form 1099-R) next year during tax time.

Answer: The law requires the custodian to withhold 20% for taxes. This is exactly like the taxes withheld from your paycheck by your employer. In most cases even that is NOT enough if you are taking an early distribution.

The distribution is taxed as ordinary income. If you are under age 59 1/2 there is a 10% penalty on top of the tax in most cases. (There are some exceptions such as for medical expenses or to purchase a first home, etc.) If you are in a 15% tax bracket, the total will be 25% with the penalty so the 20% withheld would not be enough. And if you were in a 25% tax bracket, you’d be short by 15% at filing time and would need to make an estimated payment of that amount immediately on that large of a distribution to avoid any chance of penalties and interest for underpayment of tax when you do file. That means you’d need to pull $20k to have $13k net of taxes.

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